Usually when you see someone from PIMCO out providing opinions it is Bill Gross on the bond market or El-Erian on a grab bag of macro issues. Rarely do we get their view on commodities, which we do now with this Q&A:
Higher Commodity Prices and the End of Economic Growth Without Inflation
”‹Commodity prices have risen before, but is this time different?
In the third of a series of Q&A articles accompanying the recent release of PIMCO's Secular Outlook, portfolio manager Mihir Worah discusses commodity prices and their potential to affect global inflation as well as opportunities and risks of investing in commodities.
Q. What is PIMCO’s long-term outlook on commodity prices and are they likely to drive global inflation in the years ahead?
Worah: Given the global supply/demand imbalances that we see, we expect commodity prices to be generally rising going forward, noting, of course, that commodity prices are volatile and that there will be differentiation among commodities. Much of this is related to the dynamics in and between developed and emerging economies.
Through the period of great moderation in the ‘90s and beyond, emerging markets were exporters of disinflation to developed markets where goods and services could be had at cheaper and cheaper prices. That is turning around via distinct channels. The primary channel is through higher commodity prices. Commodities trade on global markets and to the extent that emerging markets are going through a particularly commodity and energy intensive phase of growth their consumption affects what U.S. consumers pay, for example, at the gas station.
Inflationary pressure from commodities will be even higher within emerging markets. The reason: commodities are such a large part of their consumption basket – for example, nearly 60% in India, compared to about 25% in the U.S.
Rising commodity prices along with reflationary policies from many developed market central banks should result in modestly higher inflation going forward. We expect developed market inflation to average about 3% and developing market inflation to average about 5% over the secular horizon.
Q. What other factors are driving, or could drive, inflation globally? What are the implications for the global economy?
Worah: Currencies may become another strong driver of inflation, especially among developed economies. We anticipate policymakers in the developed world will attempt to make their economies more competitive via a cheaper currency, which likely will, for net importers like the U.S., lead to higher inflation.
Also, as emerging economies face their own inflationary pressures they may find that they cannot continue to couple their currencies to the U.S. dollar and to combat inflation they need to let their currencies appreciate. This is another channel by which emerging markets may export inflation to developed nations that buy their goods.
Some inflation watchers have expressed concern about wage growth in emerging markets – for example, 20% a year in China. However, that is often being offset by strong productivity gains, and although it is something we are watching, we do not yet see a direct link between wage growth in these regions and developed market inflation.
Finally, in our view, the biggest implication for the global economy of these dynamics is that the goldilocks days of the '90s where nations could have strong growth and low inflation simultaneously are gone. Perhaps the only way to address the tradeoff is through new forms of repression like raising margin requirements on commodity investments. While such measures may be temporarily successful, in the long run fundamentals will exert themselves.
Q. In a recent commentary, you argued that overall rates of inflation are likely to diverge from core rates that exclude volatile food and energy costs and are the focus of central bankers. Could you explain that view, and would such a trend raise the risk of monetary policy error?
Worah: As discussed earlier, it is our view that recent increases in commodity prices are not transitory. They may not increase at the rapid pace seen recently, but they should continue to increase at a pace faster than, on average, the Federal Reserve’s 2% target for inflation.
If, as we expect, headline inflation continues to outpace core inflation, or if the gap widens, there is a risk central bankers could lose credibility over time, causing an unanchoring of inflation expectations. That could raise the risk of monetary policy error; the Fed persistently looks through and allows steady erosion in consumers’ purchasing power.
That said, we are not predicting an inflationary spiral resembling the 1970s, for several reasons. People arguably had less faith in the central bank back then and so inflation expectations became unanchored easily. Also, unions generally had more clout in that era and could demand higher wages to match inflation expectations. The situation is different today.
Q. For investors seeking attractive real return, what are the opportunities and risks in commodities? What other asset classes have the potential to perform amid inflation?
Worah: Over long periods of time commodities have given investors a positive real rate of return (a return above inflation). The main risk would be to not understand that commodities are a volatile asset class; prices will not go up in a straight line and there could be periods of negative returns.
We feel many investors are under allocated to commodities. So just making the basic investment in commodities could potentially provide them a hedge against inflation, and that is the primary benefit.
The commodities that we like have two characteristics in common:
Clearly, some aspect of the recent rise in commodity prices has been related to increasing leverage in the system and ever lower real interest rates. On a fundamental basis, we generally tend to avoid commodities that depend on ever lower real rates and increasing leverage rather than increasing global growth, and gold is an example of this.
Aside from commodities, equities are an asset class that could perform well in periods of gradually rising inflation. However, I'll leave further comment to PIMCO's equity experts.
But let me touch upon one other asset class that we feel is very important: inflation-linked bonds. In the U.S., for example, they have the same credit risk as regular U.S. Treasuries, but the interest payments and principal are linked to the rate of inflation. To be sure, there is currently a valuation issue with inflation-linked bonds as real rates on such bonds are low. But we believe those rates are likely to stay low – one way for developed markets to escape from their debt overhang is by artificially keeping real rates low, either through regulation or through higher inflation via inflationary/low-rate policies. So in our view, inflation-linked bonds have the potential to hold their value while serving as a cornerstone of an inflation-hedging strategy.
Finally, I would argue in this environment investors are ill-served by passive strategies that lock in these low real rates of return. Investors should seek out prudently managed active strategies that provide the benefits of inflation-linked bonds while attempting to enhance the offered yields.
Link to original source:
http://www.pimco.com/EN/Insights/Pages/Higher-Commodity-Prices-and-the-End-of-Economic-Growth-Without-Inflation.aspx
Higher Commodity Prices and the End of Economic Growth Without Inflation
- ”‹We expect commodity prices to be generally rising going forward, though with volatility and differentiation among commodities.
- Emerging markets going through a particularly commodity and energy intensive phase of growth may affect what developed-world consumers pay for commodities.
- Currencies are another factor. If developed-world policymakers attempt to make their economies more competitive via a cheaper currency, that could lead to higher inflation for those that are net importers.
”‹Commodity prices have risen before, but is this time different?
In the third of a series of Q&A articles accompanying the recent release of PIMCO's Secular Outlook, portfolio manager Mihir Worah discusses commodity prices and their potential to affect global inflation as well as opportunities and risks of investing in commodities.
Q. What is PIMCO’s long-term outlook on commodity prices and are they likely to drive global inflation in the years ahead?
Worah: Given the global supply/demand imbalances that we see, we expect commodity prices to be generally rising going forward, noting, of course, that commodity prices are volatile and that there will be differentiation among commodities. Much of this is related to the dynamics in and between developed and emerging economies.
Through the period of great moderation in the ‘90s and beyond, emerging markets were exporters of disinflation to developed markets where goods and services could be had at cheaper and cheaper prices. That is turning around via distinct channels. The primary channel is through higher commodity prices. Commodities trade on global markets and to the extent that emerging markets are going through a particularly commodity and energy intensive phase of growth their consumption affects what U.S. consumers pay, for example, at the gas station.
Inflationary pressure from commodities will be even higher within emerging markets. The reason: commodities are such a large part of their consumption basket – for example, nearly 60% in India, compared to about 25% in the U.S.
Rising commodity prices along with reflationary policies from many developed market central banks should result in modestly higher inflation going forward. We expect developed market inflation to average about 3% and developing market inflation to average about 5% over the secular horizon.
Q. What other factors are driving, or could drive, inflation globally? What are the implications for the global economy?
Worah: Currencies may become another strong driver of inflation, especially among developed economies. We anticipate policymakers in the developed world will attempt to make their economies more competitive via a cheaper currency, which likely will, for net importers like the U.S., lead to higher inflation.
Also, as emerging economies face their own inflationary pressures they may find that they cannot continue to couple their currencies to the U.S. dollar and to combat inflation they need to let their currencies appreciate. This is another channel by which emerging markets may export inflation to developed nations that buy their goods.
Some inflation watchers have expressed concern about wage growth in emerging markets – for example, 20% a year in China. However, that is often being offset by strong productivity gains, and although it is something we are watching, we do not yet see a direct link between wage growth in these regions and developed market inflation.
Finally, in our view, the biggest implication for the global economy of these dynamics is that the goldilocks days of the '90s where nations could have strong growth and low inflation simultaneously are gone. Perhaps the only way to address the tradeoff is through new forms of repression like raising margin requirements on commodity investments. While such measures may be temporarily successful, in the long run fundamentals will exert themselves.
Q. In a recent commentary, you argued that overall rates of inflation are likely to diverge from core rates that exclude volatile food and energy costs and are the focus of central bankers. Could you explain that view, and would such a trend raise the risk of monetary policy error?
Worah: As discussed earlier, it is our view that recent increases in commodity prices are not transitory. They may not increase at the rapid pace seen recently, but they should continue to increase at a pace faster than, on average, the Federal Reserve’s 2% target for inflation.
If, as we expect, headline inflation continues to outpace core inflation, or if the gap widens, there is a risk central bankers could lose credibility over time, causing an unanchoring of inflation expectations. That could raise the risk of monetary policy error; the Fed persistently looks through and allows steady erosion in consumers’ purchasing power.
That said, we are not predicting an inflationary spiral resembling the 1970s, for several reasons. People arguably had less faith in the central bank back then and so inflation expectations became unanchored easily. Also, unions generally had more clout in that era and could demand higher wages to match inflation expectations. The situation is different today.
Q. For investors seeking attractive real return, what are the opportunities and risks in commodities? What other asset classes have the potential to perform amid inflation?
Worah: Over long periods of time commodities have given investors a positive real rate of return (a return above inflation). The main risk would be to not understand that commodities are a volatile asset class; prices will not go up in a straight line and there could be periods of negative returns.
We feel many investors are under allocated to commodities. So just making the basic investment in commodities could potentially provide them a hedge against inflation, and that is the primary benefit.
The commodities that we like have two characteristics in common:
- They are geared to global growth.
- There are supply constraints.
Clearly, some aspect of the recent rise in commodity prices has been related to increasing leverage in the system and ever lower real interest rates. On a fundamental basis, we generally tend to avoid commodities that depend on ever lower real rates and increasing leverage rather than increasing global growth, and gold is an example of this.
Aside from commodities, equities are an asset class that could perform well in periods of gradually rising inflation. However, I'll leave further comment to PIMCO's equity experts.
But let me touch upon one other asset class that we feel is very important: inflation-linked bonds. In the U.S., for example, they have the same credit risk as regular U.S. Treasuries, but the interest payments and principal are linked to the rate of inflation. To be sure, there is currently a valuation issue with inflation-linked bonds as real rates on such bonds are low. But we believe those rates are likely to stay low – one way for developed markets to escape from their debt overhang is by artificially keeping real rates low, either through regulation or through higher inflation via inflationary/low-rate policies. So in our view, inflation-linked bonds have the potential to hold their value while serving as a cornerstone of an inflation-hedging strategy.
Finally, I would argue in this environment investors are ill-served by passive strategies that lock in these low real rates of return. Investors should seek out prudently managed active strategies that provide the benefits of inflation-linked bonds while attempting to enhance the offered yields.
Link to original source:
http://www.pimco.com/EN/Insights/Pages/Higher-Commodity-Prices-and-the-End-of-Economic-Growth-Without-Inflation.aspx
